The investment volatility-dampening role of foreign aid in poor sub-Saharan African countries

Abstract

Sustained investment is required for economic growth. Investment however often experiences severe volatility in poor countries, making spending plans difficult to formulate, and diminishing growth potentials. Foreign aid serves as an important source of complementary financing for sustained investment. This paper thus studies the effect of aid inflows on total investment volatility in 19 heavily indebted poor sub-Saharan African countries over the period 1980–2018. Employing the cross-sectionally augmented distributed lag (CS-DL) estimation technique for long-run coefficients in dynamic heterogeneous panels with cross-sectional dependence along with bootstrap panel causality testing, we show that aid has an inverse relationship with investment volatility. We thus conclude that aid can be viewed as a dampening factor for investment volatility in poor countries. We also show that the ability of sudden reductions in aid inflows to trigger investment volatility is bigger than the ability of sudden increases in aid inflows to lower investment volatility.